The two private-equity firms said in recent filings that
regulatory guidelines may limit the amount of loans they can
access to finance buyouts. That might force them to increase the
amount of their own money used for purchases, potentially
hurting returns.

The Federal Reserve, the Federal Deposit Insurance Corp.
and the Office of the Comptroller of the Currency announced the
recommendations as high-risk loan volume reached record levels
last year amid weakening underwriting practices. While firms
typically disclose all material risks to their business in
regulatory disclosures, New York-based KKR and Apollo’s filings
may mark the first time the potential effects of the leveraged-lending guidance have been included in their annual reports.

The guidelines may “disproportionately affect the private-equity firms because the amount of leverage they can take on has
a direct effect on their equity returns,” Richard Farley, a
partner in the leveraged finance group in New York at law firm
Paul Hastings LLP, said in a telephone interview.

Regulators are seeking to set minimum standards in a market
that saw its largest year of issuance in 2013 with $353.4
billion of new loans arranged, according to data compiled by
Bloomberg. Issuance of covenant-light loans, which lack typical
lender protections, rose to $311.4 billion in 2013 from $105.7
billion in 2012, the data show.

‘May Suffer’

Private-equity firms use loans to back their leveraged
buyouts, as well as invest in the debt directly through their
credit units.

KKR, in its annual filing on Feb. 24, said regulatory
actions aren’t designed to protect holders of “interests” in
its business and “often serve to limit our activities.”

“Federal bank regulatory agencies have issued leveraged-lending guidance covering transactions characterized by a degree
of financial leverage,” the firm wrote in the filing. “To the
extent that such guidance limits the amount or cost of financing
we are able to obtain for our transactions, the returns on our
investments may suffer.”

Kristi Huller, a KKR spokeswoman, declined to comment.

Apollo brought the matter to the attention of its investors
in its annual regulatory filing on March 3, using similar
wording.

Regulatory Micromanaging

“To have a blanket number like that is micromanaging too
much from a regulatory point of view,” Black said Feb. 28 at
Columbia Business School’s Private Equity and Venture Capital
Conference in New York. “Different industries have different
growth rates” and other factors.

Charles Zehren, a spokesman for Apollo at Rubenstein
Associates, declined to comment.

“The OCC has issued some guidance, but it hasn’t issued a
rule,” David Rubenstein, co-founder of the Carlyle Group LP,
said March 26 at the Thomson Reuters Third Annual PartnerConnect
East conference. “The banks are very careful about what they do
and I think they might have some deals that they might not do
that they would have otherwise done. But generally there are a
lot of banks out there and there’s a lot of non-banks that are
also available to provide lending, so it’s not a big problem for
us.”

Fed Concerns

No similar warnings appeared to be contained in the 2013
annual filings by Carlyle and Blackstone Group LP. Randall
Whitestone, a Carlyle spokesman, declined to comment. Peter
Rose, a Blackstone spokesman, couldn’t immediately comment.

The Fed, the FDIC and the OCC said in March 2013 that a
leverage level in excess of six times total debt to earnings
before interest, taxes, depreciation and amortization “raises
concerns for most industries.”

The absence of “meaningful” covenants is a sign that
“prudent underwriting practices have deteriorated,” the
regulators said in a March 21 statement accompanying the release
of the guidelines. The advisory also said underwriting standards
should consider a borrower’s ability to repay and “delever to a
sustainable level within a reasonable period.”

The regulators followed up with letters that said banks
should establish policies that deter the origination of loans
classified as having a deficiency that might lead to a loss.

BDC Warnings

Leveraged loans are rated below BBB- by Standard & Poor’s
and less than Baa3 at Moody’s Investors Service. There have been
$73.5 billion of new loans arranged in the U.S. this year,
according to Bloomberg data. Collateralized loan obligations are
a type of collateralized debt obligation that pool high-yield,
high-risk loans and slice them into securities of varying risk
and return.

It’s not just private-equity firms that have alerted
investors about the guidelines.

KCAP Financial Inc., a business development company, which
includes a middle-market investment business, as well as the
asset-management groups Katonah Debt Advisors LLC and Trimaran
Advisors LLC, warned about the guidelines in its annual filing
on March 13. It said the leveraged-lending guidance may affect
the ways in which banks originate loans, in which it invests.

‘Stay Tuned’

Art Penn, chief executive officer of PennantPark Investment
Corp., a BDC, was asked in a Feb. 6 earnings call about how the
guidance would affect the firm and its lending practices,
according to a transcript of the call.

“There is a large chatter about the regulations and how
they’re impacting banks,” Penn, who is based in New York, said
on the call. “As the year progresses through 2014, we’ll see if
it becomes material and we’ll see if it’s helpful to middle-market lenders like BDCs.”

Loans in the middle market are typically “less leveraged
and usually” come with more covenants, Penn said in a telephone
interview. These loans are often “priced more rationally” than
largely syndicated loans sold to CLOs and mutual funds.

The broadly syndicated market is being driven by the influx
of cash from these investors, which are forced to purchase
assets, and the increased investor appetite allows deals to be
marketed more aggressively, with higher leverage and fewer
covenants, he said.

“With regulation, with Dodd-Frank, with Basel III, we hope
that the opportunity will be there for BDCs and other vehicles
that are there, to fill the gap for smaller and mid-size
businesses,” he said in the interview.